These stories are common among option traders. However, just as common are the stories about people who bought a stock option and lost everything…. The result is a fairly divided set of opinions among traders regarding the practical use of stock options. Some think everyone should trade options, other think absolutely no one should trade options. They provide better more efficient use of investable cash.
Relative to trading the underlying stock itself, stock options are cheap. Options allow smaller traders to take control of more expensive stocks for a fraction of the price. Apple Computer is one of the most popular and heavily traded stocks. For most average traders, taking a large position in AAPL is prohibitive. Here, you see the cost of buying a call option is a fraction of the cost of buying the stock. For a swing trader, this makes much more sense. Watch this special video to learn about a strategy that: Pays you up front.
Drawdown is a very important factor when considering a trade. Stock options help traders by reducing the drawdown. For those of you who may not be familiar with the term, drawdown is the amount of money that your overall account loses when the trade goes down. The way we figure drawdown is with the following formula:.
When you use the stock option to make the trade, it is impossible to lose more than you have paid for the stock option. The option would be less damaging to your overall account dollar for dollar if you held the option vs. When you buy a stock option the ROI is much better if the trade goes in your favor. Not a bad profit and frankly not a bad ROI. We can use this option projection chart to see the future possibility of the trade. While dollar for dollar we would make just a little bit less with the option trade, in terms of capital at risk, our ROI is substantially higher.
If that was the entire story then everyone would be an options trader. Unfortunately, this does not tell the entire story. Leverage is a double edge sword. Leverage means things happen faster. In trading, this means you can profit twice as fast, but you can also lose twice as fast. I first discovered leverage when I learned about trading on margin. When trading on margin, you immediately get twice the buying power. This means the ROI is double when the trade goes up. But when the trade goes down, the loss is double as well!
Options provide leverage because they allow you to control a large amount of stock for a fraction of the price. When the trade goes up, proportionally it creates a huge ROI. The ROI loss is of the capital at risk. If you compare it to your overall account and use good money management, it does not need to impact your overall account the same way that it impacts the individual loss.
A lot of people look at options this way and immediately think the risk is not worth the reward. What most people do is they use the leverage of options to over leverage themselves. Then when the trades goes bad they lost everything! When you buy a stock your ownership will not cease to exist. Even if the stock goes down, you still own it. But with a stock option, there is a clock that is counting down. Once expiration day comes, that option ceases to exist.
This introduces a new component of trade management. Not only do we have to think about account draw down, but we also have to use time management to manage the calendar. My general rule is to sell the option 2 weeks before expiration regardless. The last two weeks are the most difficult because of the time decay curve.
As you can see in this image below, the last 2 weeks are when the time decay curve accelerates and it makes it very difficult to make money buying options. For this reason, a lot of people choose to become an option seller rather than an option buyer.
Option selling puts these odds in your favor but takes on a new risk of being short options. Option buying has its advantages and option selling has its advantages. Individuals have to decide what works for them. Stock options are a powerful tool available to traders. When deployed properly they can provide great income opportunities. As an option buyer, the odds are somewhat set against you, however, the use of the option will ultimately lower your capital risk, lower your capital requirements, and increase your ROI.
As an option seller, the odds are more heavily in your favor. However, if you misuse the tool or miscalculate the direction of the trade, you could end up with a very unfavorable drawdown on your account. At the end of the day using stock options as a trading tool is a personal choice. Each trader is individualistic and you need to fully understand the risks of options as well as the benefits before entering trades with them.
July 28, at 2: Your email address will not be published. The information presented on this website and through TradeSmart University, providing stock market trading classes and option trading education programs, is for educational purposes and is not intended to be a recommendation for any specific investment.
All stock market trading classes, options trading education, and courses are examples and references and are intended for such purposes of education. The risk of loss trading securities, futures, forex, and options can be substantial. Individuals must consider all relevant risk factors including their own personal financial situation before trading. Options trading involves risk and is not suitable for all investors. It is the official position of TradeSmart University to encourage all students to learn to trade in a virtual, simulated trading environment where no risk may be incurred.
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So here we go. The Good about trading stock options There are three main reasons people choose to buy stock options: Lower Capital Requirements Relative to trading the underlying stock itself, stock options are cheap. I heard one trader say it this way: Take AAPL for example: With a stock option, all of that changes. Look at this option chain: Lower Overall Drawdown Drawdown is a very important factor when considering a trade.
The way we figure drawdown is with the following formula: But the same option trade would yield a much higher ROI. Here you see the good of buying stock options. With the option you can: The bad about trading stock options Leverage is a double edge sword. This is the appropriate way to think of using options.
Money management is your key to overcoming the ROI leverage risks associated with option trades. Wrap up Stock options are a powerful tool available to traders. One Comment Liz Milne July 28, at 2: Leave a Reply Cancel reply Your email address will not be published.More...